Short-selling bans don’t work, paper finds

A new paper from the World Federation of Exchanges (WFE) concludes that regulators should not ban short-selling, even during periods of heightened market volatility.

The global trade group of stock exchanges has published a paper that reviewed the academic literature on short-selling bans. The paper found that the evidence is almost unanimous in concluding that bans have negative effects on market functioning, including reduced liquidity and weaker price discovery.

“Indeed, the evidence suggests that banning short-selling during periods of heightened uncertainty seems to exacerbate, rather than contain, market volatility,” the WFE said.

The paper also reported that the research indicates short-selling curbs can have negative spillover effects, such as impacting derivatives markets or pushing traders into over-the-counter markets.

The paper found that bans can be particularly damaging to markets with “a relatively high amount of small stocks, low levels of fragmentation, and fewer alternatives to short-selling.”

As a result, the WFE concluded that emerging markets should be particularly wary of bans on short-selling.

The paper came in the wake of several European regulators imposing short-selling restrictions in response to plunging markets.

Regulators in Canada have taken the opposite approach. They have declared that short-sellers aren’t to blame for the recent market weakness, and they’ve defended the importance of short-selling to investor portfolios, risk management and market quality.

“Based on the existing evidence, the WFE recommends that financial regulators do not introduce short-selling bans, as the academic literature demonstrates not only their lack of effectiveness, but their negative impact on market quality,” said Nandini Sukumar, CEO of the WFE, in a statement.

“We would urge jurisdictions that have imposed such bans to reconsider in the light of the evidence,” she added.

James Langton

James is a senior reporter for Advisor.ca and its sister publication, Investment Executive. He has been reporting on regulation, securities law, industry news and more since 1994.